An Elegant Proposal from the Brits

It’s long seemed obvious to me that without large injections of fresh capital, all the other efforts to deal with the ever unfolding financial crisis would prove inadequate. Or even counterproductive. The official debate has finally swung in this direction but the question of how best this might be achieved remains a tricky one.

Of all the approaches I’ve seen so far, I’m most taken with that put forward by the Brits. Things may change, since negotiations are still very much underway, but at the core of their proposal is this elegant solution:

The way in which the money will be raised has also been simplified. The government may have to underwrite an issue of ordinary shares. This would give pre-emption rights to existing investors, and those shares not taken up will be owned by the government. These could be placed in a new bank reconstruction fund that would hold them until conditions improve.

Not only are the property rights of current shareholders respected, it sidesteps any need for the existing capital base to be wiped out before new capital can be supplied. This dire prospect was a serious drawback of many other recapitalisation schemes since it pretty much guaranteed that private capital would, in a climate of such extreme uncertainty, simply sit on its hands.

Under this plan, that’s no longer the only rational approach; instead it becomes a matter of deciding whether the proposed capital structure is sufficient to weather the storm. In principle, this is no different to the kind of decision capital always has to make. At the same time, existing shareholders would pay a heavy price through dilution if they chose not to take up their entitlement. Together with the damage already done to the value of their shares, this ensures a decent balance is maintained between risk and reward.

Should a first round of recapitalisation prove inadequate (as seems to me likely given the scale of the underlying problems), precisely the same approach can be used again. And again.

Much can, and probably will, go wrong and I have little doubt exceptionally difficult times lie ahead even with the very best of plans. Still, if something like this does become the new black for financial officialdom, the odds on a truly catastrophic outcome will have lengthened a good deal.

I for one share your view that the balance between risk and reward for public company managers has been lamentably out of line for a long time. And that these distorted incentive structures have played a significant part in the current debacle. Quite what the best solution to this dilemma might be is a larger topic than I care to try to take on here.

Still, having said that, I don’t see how it follows that other topics (like the need to recapitalise the financial system) aren’t also worthy of comment and analysis.

The best part of the British proposal as I understood it was the bit where they explicitly required participating banks to resume lending, since that addresses the Main Street problem.

This also seemed to be the worst part because government-inspired lending sounds oddly like what got us into all this!

I certainly agree that the recapitalisation method seems very elegant.

JC, what do you mean by ‘being created’? First, almost the whole OECD does this. Secondly, it is strongly arguable that this was always implicit and they have merely made it explicit – like the US and the GSEs. I imagine you agree that explicit is better than implicit in the case of government guarantees, because the implicit ones are always denied until called!

As I noted in the post, JC, there’s probably quite a good chance another round of recapitalisation will eventually be necessary. Maybe even a few more. Recaps seem preferable to the purchase of securities because they address what I see as the real underlying problem while leaving price discovery to the markets.

Patrick, I’m much less sure about the other aspects of the package. Like you, I can’t see that direct government interference in lending decisions is a good idea. I also wonder about the merits of issuing wholesale guarantees of interbank lending. Not only is it likely to generate all manner of unintended consequences but removing this prop may not be easy.

Also I would require each bank borrowing from a central bank to post to LIBOR not just its theoretical interbank rate but also the actual rate it is borrowing from the Fed at.

Because on the analysis of eg NG’s latest favourite pundit, LIBOR is high really only because banks aren’t using it anymore and because this is a de facto subsidy for banks. Which sounds a bit like cheating to me.

Hempton’s comments struck me as a bit of a rant, TH. And, as BBB put it, rather light on.

Everyone knows that trust has been holed below the waterline. In any case, concerns about adequate capitalisation are hardly irrelevant to whatever trust might still exist.

I’ll say one thing for him; he’s a brave man. To confidently assert that capital isn’t a problem is a big call. Even if his overall loss estimate turns out to be correct, so what? Nobody knows right now, nobody can know and real world indicators are still pointing down. That uncertainty is just part of what the markets are trying to discount, and the $700 billion he’s convinced will pour out of the US financial system in positive cash flow over the next two years is, so far as the market is concerned right now, more akin to a hopeful maybe. In troubled times, I don’t really think this takes the place of equity.

His bottom line, in any case, is nationalisation. The point he’s so eager to make is that this would work not because it injects equity but because it would inject confidence. A semantic quibble, in my view. It would work (assuming of course it does) because the system would be guaranteed by those who control money creation. One might just as well say that the entire equity of the American taxpayer would have been committed to the system’s survival.